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Democrats reach deal on $450 trillion swaps market

Big banks would be required to divest 'risky' derivatives units

By

RonaldD. Orol

WASHINGTON (MarketWatch) - As bank reform legislation failed to pass a key test vote in the Senate, Democrats released a deal late Monday they struck amongst themselves over how to regulate the opaque $450 trillion derivatives market.

There are a number of controversial measures in the derivatives package, none more so that a provision that would have commercial banks divest their entire derivatives divisions if they want to continue to have access to the government safety net.

The deal on derivatives comes after Republicans voted unanimously to oppose a key procedural motion put forward by congressional leaders that would have allowed for a debate on the financial institution bill by the full Senate. Democrats are set to schedule another vote on beginning Senate debate on bank reform as soon as Wednesday. Read about bank reform vote.

Large financial institutions argue that divesting these units would limit their ability to lend to Main Street because of billions lost in profits. Lincoln and others defend the measure that they believe would drive a stake into the conundrum of institutions becoming "too big to fail," by reducing the size and riskiness of big banks.

"I'm surprised that it survived," said University of Maryland Professor Michael Greenberger. "It is representative of the fact that the efforts to keep banks away from proprietary and dangerous trading, along the lines of the Volcker rule, has gained a lot of traction."

The so-called Volcker rule, named after ex-Federal Reserve chief Paul Volcker, who chairs President Barack Obama's economic advisory panel, would bar big commercial banks from making speculative derivatives and stock investments for their own accounts.

The package of derivatives reforms, which was agreed to after the Senate Agriculture Committee and the Senate Banking Committee each approved their own derivatives legislation. The combined package would require a large segment of the derivatives market to go through transparent clearinghouses, which are intermediaries between buyers and sellers, and exchanges.

The advantage of clearinghouses, proponents say, is that they promote greater transparency.

It would also require large financial institutions known as "major swap participants" to maintain additional capital when conducting swap trades. These institutions would need to report their trades to regulators as well.

GOP support?

The derivatives legislation has some Republican support. Sen. Charles Grassley, R-Iowa, was the only Republican to support this provision and broader derivatives legislation approved by the agriculture panel.

But Matt Canter, spokesman for Sen. Kirsten Gillibrand, D-N.Y., said there are significant questions about whether the measure having banks divest swap desks will stay in the bill.

He pointed out that the measure was not in the version of reform legislation approved by the Senate Banking Committee; nor was it something the Obama administration has sought.

However, Canter stopped short of saying that Gillibrand opposed the measure. According to a Barclays Capital report, Gillibrand has indicated that it is unlikely the provision will still be present when the legislation comes up for a vote later Monday.

Exemptions at issue

However, lawmakers are squabbling over exemptions to the clearinghouse provisions in the legislation, in large part because they add significant costs to the transactions and bring derivatives transactions out of the dark.

In their negotiations over the shape of the bill, Democrats agreed on Monday to remove a provision pushed for by Berkshire Hathaway
BRK.B, -1.14%BRK.A, -1.00%
that would have exemption existing derivatives contracts from the requirement to post collateral. Berkshire has a $63 billion derivatives portfolio, although Berkshire's Warren Buffett has called them "financial weapons of mass destruction."

Greenberger, who served as director of the trading and markets division at the Commodity Futures Trading Commission between 1997 and 1999, argued that existing swaps would have been considered exempted from new regulations.

However, Greenberger said he suspected Buffett wanted Congress to clarify that the exemption was there. Instead, the legislation will seek to make clear that existing swaps are not exempted.

"This effort is backfiring on Buffett," Greenberger said.

The bill would exempt many commercial end-users of derivatives -- such as airlines, manufacturers and pension funds -- from the clearinghouse requirement. Republican lawmakers argued that the exemptions aren't expansive enough and capture some commercial companies.

Commercial institutions use derivatives to hedge production costs, but many would be forced to stop employing them without an exemption, because of the increased costs that go with posting margin.

Foreign exchange swaps, global financial market for trading of currencies, will be regulated by the Commodity Futures Trading Commission, like all other Wall Street contracts. However, lawmakers added a provision that would give the Treasury Department the authority to reject new CFTC rules for this market.

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